*There are two basic steps to finding undervalued stocks: developing a rough list of stocks you want to investigate further because they meet your basic screening criteria, then doing a more in-depth analysis of these stocks by examining the financial data of the selected companies.
*Valuation of a stock can be of the following types
Overpriced/Overvalued
Fairly price
Underpriced/Undervalued
2 basis approaches to stock valuation
① Discounted cash flow method
② Relative valuation method
① Discounted cash flow method
Dividends which play a key role and NOT earnings directly
Future estimated dividends are discounted to the present value at the investors required rate of return to determine the intrinsic value of the stock
Value of stock = FUTURE DIVIDEND
(Investors required －constant
Rate of return growth rate)
Eg: Company X paid a dividend of 1$ per share and is expected to pay devidends every year
Company expected to grow at 8%
Future dividend = Current dividend ×(1 + growth rate)
= 1 (1+0.08) = 1.08$
Investor desired rate of return = 10% = 0.01
Value of stock = 1.08 = 1.08 = 50$
(0.10 – 0.08) 0.02
A price greater than 50$ results in lower rate of return of 10% and vice versa
Expected rate of return = future dividend + 8%
Current stock price
= 1.08 + 8% = 9.96%
55
The above valuation model can be adapted to included variable dividend growth rates
When company retains and reinvests its earnings in new investments, its share price increases
② Relative valuation method
○a P/E ratio = Price (current)
EPS
Generally P/E ↑stock price ↑
Company stock price = P/E × EPS
Compare the company’s P/E ratio with industry P/E ratio to see if the company is overvalued or undervalued
By definition, EPS include extraordinary gains and losses that are not recurring
The inclusion of a onetime gain overstates EPS and vases P/E ratio to be lower
Stock might appear to be undervalued
Another stumbling block is the use of historical earnings versus future earnings
PEG (Price/Earnings growth) ratio
PEG = P/E ratio
Estimatedfuture growth in EPS
Forward earnings are the estimated earnings of a company is expected to earn in coming years
Use of historical earnings results in higher P/E ratio than using forward earnings during period of growth and vice versa
Use of net income results in higher P/E
Low PEG ratio → undervalued stock
High PEG ratio → overvalued stock
Low PEG ratio means that the investor (< 1) pays less for estimated future earnings (> 1)